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Monday, October 13, 2008

Outlook for the currency futures

I have been very interested in the evolution of exchange-traded currency derivatives in India. Some prominent people in the field do not share this sense of possibility and importance. As an example, on 19 September, Jamal Mecklai wrote in Business Standard on this subject:

Indeed, the volume of trading in the first few days -- although quite impressive as compared to start-up futures contracts anywhere in the world -- has barely crossed $50 million on a single day, a drop in the ocean compared to even our own OTC market. Of course, futures volumes are unlikely to ever be much more than a bucket in the ocean in the global market, for instance, currency futures trades constitute just about 2-3 per cent of the OTC market. So, while I applaud the move, it is important that we don't get carried away with great expectations -- we need to understand what is the real role that currency futures can play in an economy, and as a step towards greater deregulation of financial markets.

First of all, for the economy at large, the impact will likely be relatively minor and at a second order. Contrary to the belief apparently held by the regulators, the government and the ever-eager exchanges, I can't see currency futures having any value as a hedging tool. They are not used as such anywhere in the world and there are several reasons for this.

I disagree with this pessimism. First, let's get a numerical grip of the OTC INR/USD forward market. The latest RBI WSS shows FCY/INR merchant forward business as being roughly $2 billion a day, and the interbank as being another $1 billion a day. (They show these numbers twice, once as `purchase' and once as `sales', and I suspect the correct turnover number is to only count it once). Putting these together, we're probably talking OTC business on INR/USD forwards of roughly $3 billion a day. 3% of this would be $90 million a day or Rs.400 crore a day.

I have an article titled Where are we on the currency futures in Financial Express today where I take stock of what has been happening on the currency futures market. The picture you see there is much unlike what Jamal is painting. But that article used data till 7th October, and I'm already running behind the events! Here's the full daily time-series of turnover and open interest:

Date

Open interest

Turnover

(Contracts)

(Rs. crore)

29/08

16387

291

01/09

24078

107

02/09

33667

187

04/09

30268

178

05/09

30311

168

08/09

30632

240

09/09

28744

244

10/09

41570

198

11/09

51050

235

12/09

55733

186

15/09

60272

232

16/09

86559

456

17/09

90731

338

18/09

86494

378

19/09

78973

307

22/09

71156

259

23/09

78025

363

24/09

89343

377

25/09

92526

223

26/09

74470

200

29/09

69005

290

30/09

88426

297

01/10

96958

418

03/10

122942

429

06/10

132866

406

07/10

148552

590

08/10

151484

614

10/10

143526

936

As we see, the turnover on the currency futures market has exceeded 3% of the OTC forward market (i.e. a threshold of Rs.400 crore) from October 1 onwards. On Friday the 10th, the turnover at Rs.936 crore was more than double of this threshold. Looking into the future, I think the story has only begun; it would not be prudent to bet that at the latest level of Rs.936 crore a day, growth will cease. So I think we have to start questioning the pessimistic view that exchange-traded currency futures can't exceed 2-3% of the OTC forward business.

In parallel, also note that there is some international evidence that private players are shifting away from OTC contracting to the safety of the exchange. So it's time to question our pessimistic assumptions about what can be done on exchange.

I also disagree with the claims about hedging. Cash settled derivatives as a risk management overlay on top of a physical position is a standard technique taught in the textbooks. There is absolutely no reason why the currency futures cannot be used for hedging - except when RBI's limit that no one person can hold over 6% of the market wide open interest comes in the way.

There also, things are getting better with the growing open interest of the market. On Friday, with open interest of 143,526 contracts, the limit of 6% gives a per-client limit of 8611 contracts or $8.6 million or Rs.40 crore.

There are tens of thousands of firms in India who have currency hedging needs (owing to economic exposure) which can be adequately met within this position limit. NSE members have their work cut out for them, scouting the countryside, identifying firms with currency exposure where the position limit is not a show stopper, and getting them going on doing hedging using currency futures.

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